Monetary Policy Targets the Average, Not You

Economic analysis by Filipe R. Costa

I came across a very interesting article on WSJ describing how the franc uptrend upends life at the Swiss borderlands. Besides portraying life near the Swiss border, the dynamics of the exchange rate movement between the franc and the euro described in the article teaches us an important lesson: Monetary policy is not aimed at solving local/regional problems and sometimes may even aggravate them, which suggests there is a need to counter it with fiscal measures in order to neutralise its negative effects.

These problems faced by local communities can be extrapolated to the Eurozone level, which may help us understand the inherent contradictions in setting interest rates and exchange rates for the Eurozone. If the more homogeneous local communities face harsh problems, just imagine what can happen at the national level! This adds weight to the argument that the ECB cannot do a proper job without fiscal integration…

Germany, Italy, Austria, and France are the four Eurozone countries with which Switzerland shares borders. Life near the border is very special, as people are divided into using the franc and the euro because it is relatively easy to establish a home in one of the countries while shopping or working at another. Many reasons help to account for the decision where to live and where to shop, but interest rates and the exchange rate between the franc and the euro are crucial, as these directly influence the income and expenses of businesses and households.

For a country that is geographically located inside the Eurozone without economically being part of it, Switzerland is a very expensive country, where prices and salaries are well above those of the surrounding Eurozone countries (and most of the rest of the world, for that matter!). With the very special status conferred by Switzerland’s offshore banking sector, and with the Eurozone’s economy sinking, the franc has been pushed higher of late. In September 2011, fearing an excess inflow of funds and the negative impact on trade that could result from such a strong currency, the SNB decided to peg the franc to the euro at the rate of 1.20. But, with the continued weakness in the Eurozone and prospects for quantitative easing on the horizon, the SNB decided to abandon the peg. Almost immediately the franc rose 40%, albeit retreating slightly during the following days.

No matter how badly Switzerland may need to let the franc appreciate or float freely, the current rate does not serve the border communities referred to above. About 300,000 workers commute each day from neighbouring countries to work in Switzerland, where salaries are higher. That number has risen during the last few years as economic conditions have been better in Switzerland than in the Eurozone. In turn people in Switzerland like to cross the borders to shop at bargain prices.

The strong franc leads to painful movements at the Swiss borders. The real estate sector is one area which well exhibits the spill over into the Eurozone, as Weil am Rhein and Constance in Germany can attest. With the franc so highly valued against the euro, everyone wants to buy a home and go shopping at the Eurozone’s edge. This pushes prices higher and leads to complaints from locals, who find it ever more difficult to buy anything with their salaries. Meanwhile, at the other side of the border, in places like Kreuzlinger, shops are closing their doors. People will continue to seek work within Switzerland’s borders while shopping and living on the Eurozone side, until there is convergence in prices and salaries at both ends.

If there was autonomy in monetary policy on both sides of the border, interest rates would have started rising in the Eurozone countries to prevent the rise in prices, while the exchange rate would lead the euro (i.e. deutschmark, French franc etc.) higher. As things stand, as there is no monetary policy to hand for these communities, they must go through a painful adjustment that involves the movement of thousands of individuals across time.

When adhering to the Eurozone, countries lose the exchange rate adjustment mechanism and are turned into the small communities referred to above. Without fiscal mechanisms to address any asymmetric shocks (which not only exist but were also underestimated by European officials), these countries need to go through very painful adjustments that lead to the migration of millions. In a perfectly flexible world that wouldn’t be a problem, but we live in a much more rigid setting that needs some kind of compensation.